A Target-Date Fund Debacle

By Ben Dolan, CFP®

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Target-date funds (TDFs) are ubiquitous in the investment world. The theory behind them is simple: a TDF will shift its allocation from stocks (considered risky) to bonds and cash (considered less risky), over time. For example, a 2050 Retirement TDF might have 90% in stock, 8% in bonds and 2% in cash in 2024. But in 2045, the TDF may have 50% in stock, 40% in bonds, and 10% in cash and cash equivalents. This shift over time reflects the desire of the average investor to take less risk as they reach retirement age by reducing the allocation to stock.

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Last week, Vanguard, one of the largest asset managers in the US, announced that they are in talks to settle a lawsuit brought by investors in Vanguard’s TDFs. On January 21 of 2022, Jason Zweig, author of the Intelligent Investor column in the Wall Street Journal, outlined the issue: 

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“At the end of 2020, Vanguard reduced the minimum investment in its institutional Target Retirement funds to $5 million from $100 million. That set off an elephant stampede, as multimillion-dollar corporate retirement plans got out of the standard target funds and into the institutional equivalents. (Clients have to sell out of one format to buy the other.)

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Last year, assets at Vanguard’s 2035 target fund shrank to $38 billion from $46 billion at year-end 2020; the 2040 fund shriveled to $29 billion from $36 billion.

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As big clients left, their sales caused the funds to offload some holdings, triggering capital gains—which could be distributed only to the dwindling group of investors who stuck around. Some had made the mistake of owning these funds in taxable accounts.”

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While many investors understand asset allocation (the mix of stocks, bonds and cash in their portfolio), less well known is the importance of asset location.

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In short, asset location is where investments are placed across tax-deferred (e.g. 401k or traditional IRA), tax-advantaged (e.g. Roth IRA), and taxable accounts (e.g. Brokerage Account). For example, the interest produced by a corporate bond fund is taxed at ordinary income rates, not more favorable capital gains tax rates. Therefore, the best asset location for a corporate bond fund is a tax-deferred account like a 401(k) or Traditional IRA, so that the income produced doesn’t unnecessarily increase the ordinary income of a client.

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Likewise, the best location of TDFs is in a tax-deferred accounts, not a taxable account. Not knowing this cost some investors BIG time. According to Zweig, one investor will owe $150,000 in federal and state taxes.

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Optimal asset location is a best practice at DCA. After all, investing is not just about how much you make, it’s about how much you keep after Uncle Sam comes for his piece.